To Rent or to Buy? Seems like we get this question alot...
In this series we're going to feature a question we get quite often, usually in the form of an email...they start off a bit like this:
"I'm on your site and I found a building I like but the rent seems high, should I just offer to buy it?"
"Hey there, found a really great building but I think with our cash we should look at purchasing, what do you all think?"
and sometimes..."I just put this building under contract, can you tell me what it's worth?"
Seriously! Let's get something 100% straight before we go any further. DO NOT PUT ANYTHING UNDER CONTRACT without a thorough review and understanding of the full dynamics of what a purchase means for your business.
So, back to the question at hand. Which clearly deserve as answer, but there's not a one-size-fits-all solution (like a lot of things in business).
Should your business rent property on a long-term basis or consider purchasing an asset for your company? Assets that can grow in value over time are attractive after all! It’s an age old question, and one we see in residential decision-making as well. Homes and apartments have been battling since cave-times...the numbers just get a bit larger in commercial real estate.
On the commercial side, the numbers are far bigger - making commitments that are much longer, and liabilities that much greater. So let’s run down the pros and cons of this choice.
For this exercise we’ll borrow from a decision-making framework (implemented by consultants, resources and psychology professionals, among many others) to help us really break down, identify and make the best decision possible for your business.
The framework is called “polarity management.” Before you start groaning from fear of consultant-speak, know that it is a useful process you can apply to many aspects of your business. Here at Tenavox we apply it to many critical product development and organizational decisions to get things into a digestible format. The goal is to take a complex “either/or” problem and transform it from a confabulating issue into a simple one. If done right, you’ll come up with a “right” decision for your business, or at least a framework for making that decision you can rely on.
What Polarity Management allows for is a problem or questions that is ongoing as opposed to finite. Your business is likely to always have an occupancy question (even after a decision is made), and traditional problem solving fails to address these continuing needs. Polarity management allows for management on an ongoing basis. Neat huh?
If you’re interested in the theory and more practice with Polarity Management, check out http://bertparlee.com/training/polarity-management/ for a great resource.
So, let’s get back to our problem. Renting or buying in commercial real estate. Well our first step is to define what the greater purpose is of our problem. In this case, I’ll take a stab at the goal, something along the lines of “To find and occupy a quality long-term commercial space for my business.” Sound OK? Good. No? Use your own greater purpose statement that works for your goals, remember it’s about your ultimate goal with your commercial space for our problem at hand. With this purpose statement/goal identified we can start working the problem itself.
With a goal and purpose identified, I find it useful to start identifying the greatest negative outcome of this decision. Something along the lines of “Our organization is left occupying a space that does not work, economically or functionally.” Basically, the fear statement is that with a wrong decision you either are left at an economic disadvantage by over-spending or over-leveraging, or perhaps your functional space prevents growth, hiring, or somehow impedes the business from doing what it needs to do for long-term success. It’s strange to think of physical space at this level but the problem is complex, I promise this will help.
Now we can identify our two polarities, left pole and right pole. In this case, Renting/Leasing VS Purchasing/Owning a commercial space. Now, the renting vs owning problem has a virtual alice in wonderland hole of factors that can amplify or hurt the decision making process. For example, loans, lease terms, security deposits, lines of credit, cash down, growth dynamics, location needs, timing, costs up front, long-term per employee costs, flexibility and many more. So, what I would suggest is starting with the upsides/downsides identified here (and visually below) as a starting point. This visual tool is free and you can play with it at your convenience FYI to make it suit your specific needs. For now, I’ll use it in a general way to get us started.
So, left pole is identified as Renting/Leasing commercial space. Let’s identify some critical upside values to leasing commercial space. Here’s 3-4 of my favorites.
- Provides flexibility in expansion/contraction through limited term
- Lower costs up-front
- More choices to find locations that fit needs
- Significantly less financial and operational commitment
With the upsides fleshed out, let’s talk the other side of the pole, downsides. Here’s a few to start with.
- Financial output is a never recovered (money out, no gain)
- Can be forced to move or vacate without recourse
- Negotiations ongoing, power held by Ownership
- Costs for “building out” space can be significant
Great, now let’s work on the right pole. Purchasing/Owning commercial space. Same drill.
- Appreciating asset (ideally) for the business that can be leveraged
- Branding of the location is yours
- Potential to create income from leasing to other users
- Consistency for employees and executives in location
- Space dynamics locked in from an expansion/contraction standpoint
- Significant initial financial output in cash
- Serious liabilities from potential lender/ownership standpoint
- Risk of financial failure if asset experiences issues with quality or leasing
- Management and Ownership creates additional responsibility beyond running the business
Awesome, now let’s get specific on the action steps for each poles upside. Here we define what how we gain and measure results from a focus on each pole in our question at hand.
Left Pole (Upsides of renting)
- Identify top five potential locations with our size needs, budget and location preferences.
- Negotiate a deal with market (or better) economic terms with term, timing, effective rent, concessions and all costs clearly defined before signing a lease. Letter of Intent.
- Explore options in the space for expansion/contraction with a focus on “what if” scenarios for growth or negative issues during the term.
- Work with qualified CRE attorney to ensure lease document is reflective of these negotiations from a business standpoint and all risks/legal points are understood.
- Occupancy, commencement and ultimate management of the lease space is handled professionally and sources for recourse and accountability are known by business to ensure quality lease experience.
(Just so you know, Tenavox can help you do EVERYTHING we just identified above on the left pole, leasing commercial space, check it out!)
Right Pole (Upsides of Ownership)
- Clearly define location needs by focusing on employee commutes/access times, operational concerns, financial commitments and size/space dynamics.
- Consider purchasing more space than your business currently needs for both growth and potential income from leasing.
- Go and identify top five potential buildings/centers that fit within your newly defined scope. Estimate costs of purchase, construction, timing and potential lending/financial liability requirements up front using commercial real estate “pro-forma” for the purchase.
- Use pro-forma calculations to quantify value of “your lease” as a renter (not an owner) in order to see what your businesses potential value to the building as a whole is.
- Wear the Landlord hat! Not the business owner hat.
These action steps above are important, specifically in ownership so I want to interject here. Purchasing and owning an asset must be looked at in two ways, the space dynamics of the business first and then the economic potential as a Landlord.
HINT: Consider drafting a pro-forma of the purchase, to learn how to do this visit our education center and Download our Book, it has 75 pages of Awesome Advice!
In order to make an accurate, developer-style, assessment of the purchase. If you want to be a Landlord (even if you do buy a single-tenant asset that fits you) it’s critical to think like one. Landlord’s make a calculation of the costs of doing a deal (even their own lease) like a commercial real estate professional. Be careful not to let the needs of the business cloud your financial judgement on the asset itself. It should be a fit for the company AND a financial fit as the ownership entity. It’s what banks, investors and ultimately you should expect to see.
OK, So with the action steps identified so we know how to get to our positives, it’s time to break it down on the other side.
Great, now let’s get specific and start breaking down some warning signs and potential red-flags early on for these poles. Note, these should be things you can literally measure or count. Be specific.
Left Pole (Renting/Leasing)
- Your initial costs seem to be getting higher than expected
- There are not options/available areas to expand or contract to suit your business over time
- The lease term/commitment seems too long for comfort
- You do not have an accurate idea of what the Landlord/Management is like, concerns with quality of building/solving issues
Right Pole (Purchasing/Ownership)
- The financial terms for the purchase are scary/too much to bear
- Lender requirements are onerous and seem too risky
- Your employees are concerned about the commute to the long-term location choice
- You do not feel comfortable renting to others or managing the asset
- You think you will outgrow this space in under 5-7 years
So now we charted the problem and I can start giving you the skinny and my opinion a long-term CRE broker, owner and developer. Take these with a grain of salt and do what's best for you...if you have questions feel free to reach out and we at Tenavox are happy to help answer things as best we can. We’re all about small business and commercial real estate.
With this built we can really break the problem down into digestible and actionable pieces. We now have goals, fears, actions and warnings that can help us predict what the right decision is. Now it is up to you! If you are concerned about long-term growth, initial financial commitment or your employees reaction to moving to a building you own that may be outside of a CBD or centrally located then factor this into your decision. Use feedback to effectively manage these expectations, survey the employee base to make sure!
On the leasing side, oftentimes the sacrifice comes down to paying more now for increased flexibility and better locations. If this suits your plans than leasing may work. Try not to too concerned with the idea that rent doesn’t appreciate, it’s just a cost. So what, it’s a cost of doing business. Frankly, you can sublease your space or assign it if you outgrow or shrink and receive far less liability than if you make a mistake in ownership. For early on in a businesses cycle I usually recommend leasing for 3-5 years to get a sense of your traction and growth, then if a purchase makes sense factor in 24 months to make the decision, find the location and build/buy/improve the asset you think is best.
One quick note: This is geared towards small business owners. If you have enough money to purchase a $100MM building in downtown CBD somewhere than you likely have a full real estate team anyway. This article is built for the 30 million small businesses that do not and want to level the playing field. Purchasing an asset that is considered “affordable” (Less than $3MM) for a normal business is a challenge, it usually means tertiary locations to the central business districts of an area. Why? Simple. The land costs and constructions costs dictate building massive assets that can be leased long term to big tenants. It’s risk/reward and focus as a real estate developer.
Put simply, these developers business is to make money leasing space, so they want to biggest possible buildings with the most space to lease. THAT is NOT your business, keep this in mind ;)
Leasing is GENERALLY the better decision for newer/smaller businesses, that’s my humble opinion but one I believe to be true. It provides you with flexibilty.
What about office condo’s?
These are sortof a mixed bag. They cost far less than typical ownership (which can be millions of dollars) for the smaller footprint your business may need. However, know this. Office condominiums should be treated like any other purchase, ask yourself, is this a GOOD real estate decision. Yes, it may fit your business and the idea of appreciating assets is attractive. But with a condo it may not be true. There are always newer condo’s being built and if you have dynamic needs the exit strategy can be tough, you may LOSE money on the purchase.
Be careful here and think about the ultimate financial goal, if it’s to make money as a business than do what the business needs first, LOCATION AND BUDGET AND SIZE, and make the real estate purchase the next step if thats the route you take. NOT the other way around.
Well hopefully this is a useful example of how to break down a complex problem in commercial real estate, we have a lot more in our series for Tenants and making better decisions at Tenavox check us out! We’re the site built for Tenants.
For even more great resources on purchasing vs leasing, check out our friends over at Fit Small Business. They have a TON of great information and help for growing businesses from marketing to real estate decisions!